New rates, new rules

Oh for a return to the good old days when the most profitable strategy for making money was to borrow on the cheap and then go and buy property and shares with your ears pinned back, maybe with a bit of negative gearing thrown in to help with the tax bill.

But the blind Freddy approach to investing is long gone and now with not just one but in all probability another Reserve Bank of Australia cut in interest rates as early as next month, investors may need to take a more realistic view of their long-term saving and investment approach.

Indeed, if traders are to be believed, the cash rate will be at a record low of 2.5 per cent in 12 months’ time. With that in mind, where is the best place for your money?

Falling interest rates can be good for property, stocks and bonds, but this time things may not pan out that way. For a start, investors have a significant amount of money on deposit and a rate cut means their income is cut. Mortgage holders may enjoy a benefit but fewer than 40 cent of households have mortgages.

In the past all investors welcomed an interest rate cut, despite the obvious reason for the move – a slowing economy.

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But now the question is whether, in today’s environment with the savings rate so high and investors and consumers still nursing their wounds from the global financial crisis, a rate cut helps or hurts the economy.

According to Goldman Sachs, cutting rates alone doesn’t have the economic impact it once had unless there are knock-on effects that also help out, such as a lower Australian dollar and a higher sharemarket.

CommSec points out that, by and large, investors have avoided the sharemarket over the past few years and have so much money sitting in term deposits that it’s almost equal to the banks’ outstanding loans. That’s unusual.

If the interest earned on those deposits falls in line with official rate cuts, then maybe consumers with even less disposable income will tighten their belts further.

That’s not exactly the result the RBA and struggling retailers would be hoping for from a rate cut.

And what if those with a mortgage opt to pay them off at a faster rate rather than spend as they did in the past when the value of their homes was rising?

Retailers and other businesses must then pin their hopes on a rebound in the global economy to give consumers the confidence to spend any additional income rather than save it.

Whatever the case, investors should be asking themselves if it’s time to tweak the portfolio.

Bonds may be considered standard safe-haven fare and they have been popular, but there is a downside – and that fact may be news to many investors who see them as the place to be in a stormy market.

Bonds look safe and they pay a regular predictable coupon. Retail investors like the relative stability of the instruments and the steady stream of income they offer.

But some market analysts suggest we could be at the peak of a bond market bubble.

A buying stampede has pushed the yield on the US 10-year Treasury bond to 1.67 per cent, close to all-time lows, but experts such as Bill Gross, the largest bond manager in the world, are warning that unless the US curbs its spending or increases taxes, bond yields will rise and investors will be burned to a crisp.

Australian Commonwealth government bonds mirror movements in their US equivalents and local yields have also fallen to historical lows.

But Chris Dickman of Altius Asset Management says government bond yields have fallen too low and when it comes to fixed income, corporate and semi government bonds offer better value.

He warns that if the RBA is less aggressive than what is already expected in the pricing of government bonds then yields will rise higher and any investor who has bought in recently will incur a capital loss if forced to sell.

For bonds to keep on delivering solid returns, interest rates have to continue to fall.

Former federal finance minister Lindsay Tanner and former Treasury secretary Ken Henry hit the headlines earlier this year when they, and others, said the $1.3 trillion super industry should own more bonds.

Oddly enough, London-based chairman of Goldman Sachs Asset Management Jim O’Neill says the opposite debate is going on right now in Britain and Europe. He says investors there have too many bonds and are shifting more money into shares.

But when it comes to asset allocation the man who sets the strategy for the $US835 billion GSAM fund and who coined the term BRIC, the acronym that stands for the four rapidly developing nations of Brazil, Russia, India and China, says there’s nothing wrong with the 60-40 rule – that is, 60 per cent shares and 40 per cent bonds.

“I think there’s an argument to be made that the world economy’s growth trend is on the rise.’’ he says. “It’s just coming from different places than anyone from my lifetime is used to. So to be shifting away from equities toward bonds simply because of what’s happened in markets in the past decade doesn’t make sense. People worry about yesterday’s wars as opposed to the future."

He says that the big rivers of growth, of opportunity, include something loosely called a “go anywhere" fund.

It’s attracting a lot of money from long-term conservative investors in the US pension fund community and allocates money to a fund that alternates between bonds and equities

“I’m eager to get us into these sorts of funds," O’Neill says. “I don’t really see anything wrong with the basic 60-40 framework, but the key is to have a flexibility of mind with sound principles about what your desired return is – rather than be too rigid on the allocation to one versus the other."

Fund managers argue that equities are still relatively cheap and offer the best potential return compared to other asset classes such as bonds. Cash and bonds might reduce the short-term risk but they miss the mark on long-term risk such as inflation.

But they would say that, wouldn’t they? And some senior stock pickers warn that earnings risk and weak global economic conditions still call for caution when it comes to the sector.

As for bonds, they’ve been on a tear now for 30 years and although the global financial crisis exposed investors who didn’t have enough of them, buying now with yields at record lows would be a brave call.

Housing is also in a trough. New housing starts, at near 135,000 in 2011-12, are proof of that. Industry analyst BIS Shrapnel predicts new housing starts will rise by just 3 per cent in 2012-13, to 141,650.

Australian shares have just enjoyed their best quarter in three years. Further gains were made in the past week and some say the medium term prospect is still favourable.

Bank stocks, and their dividends, have been in favour with investors while resources have lagged as investors worry about the slowdown in China.

Local fund managers hold a record 3 per cent overweight position in the banks relative to the major S&P/ASX 200 Index, according to the June quarter Australian Bureau of Statistics financial accounts data.

The S&P/ASX 200 Banks Index has gained 19 per cent so far this year, compared to a 10 per cent rise for the broader index and a 5 per cent drop in the resources sector.

Investors have been lured by the dividends the banks pay; for example CBA shares are yielding 6 per cent – which is 8.6 per cent fully franked.

The major banks have also taken notice of the rating agencies and some investors, and have made moves to reduce their reliance on offshore borrowing. It’s now down to 17.5 per cent of total liabilities from a peak of 25 per cent before the financial crisis.

From a relative valuation point, the equity risk premium (the excess return of the sharemarket over the bond rate) is very high, implying shares are cheap.

“Now is not the time to think tactically," he says. “Think strategically."

That means thinking about time horizons, goals and what sort of risks you are willing to take.

“The older you get the more important it is to make sure you do the simple stuff right," he says. “For example, decide how many shares you want compared to bonds and then, after that, worry about what shares to own. Get the mix that suits your age.’’

On asset allocation, he advises against putting too much into equities in the current conditions. He thinks the short-term outlook for shares is a bit toppy but once we get through that, cash and bonds won’t give the returns of the past few years while shares will outperfom bonds in the medium term.